05/15/2013 08:08 am ET Updated May 16, 2013

Credit Rating Agencies Loosening Standards Again, In Same Dynamic That Preceded Financial Crisis

NEW YORK -- Huxley Sommerville, group managing director at Fitch Ratings, increasingly fears another massive financial crisis. Ask him why and he tells the story of a recent deal his credit rating agency failed to secure.

Last month, a group of Citigroup bankers contacted Fitch’s New York headquarters, hoping to convince its analysts to deliver their seal of approval for a bond issue. In essence, Citi needed Fitch to conclude that the landlord of an iconic Manhattan office tower should be considered as trustworthy as the government of the United States.

Citigroup had recently partnered with Deutsche Bank to lend $783 million to the owner of the Seagram Building, an architectural gem on Park Avenue in midtown Manhattan. Now, its bankers were in the process of turning that huge loan into multiple bonds, hoping to resell the debt to investors in pieces. They would turn one loan into commercial mortgage-backed securities.

But doing the deal required the rating agency's blessing: Fitch had to assign a slice of those bonds its coveted "AAA" rating, an action that would officially make the debt about as sound as a savings bond from Uncle Sam.

For Fitch, going along would have netted hundreds of thousands of dollars in fees. Still, its analysts balked. In making their pitch, the Citigroup bankers relied on a model that assumed rents for tenants in the building would increase by nearly 35 percent over the decade -- an optimistic scenario. If rents don't climb that much, the bonds would be riskier. The landlord may be unable to manage the shortfall, and the bondholders could get stiffed.

The analysts at Fitch were well aware of recent history and the popular perception that credit ratings played a not-insignificant role in turning reckless speculation in American real estate into kindling for a global financial inferno. Credit rating agencies are widely seen as having demonstrated the intellectual integrity of a political campaign advertising shop in the runup to the crisis, eagerly signing off on whatever message the client paid for.

Not this time, the Fitch analysts said.

“We told them we’re not going to underwrite based on an increase in the current rent roll,” Somerville told The Huffington Post. “We’re not saying they’re not going to achieve what they’re saying they’re going to achieve. We’re just saying AAA bondholders shouldn’t have to depend on that risk.”

Fortunately for the Citigroup bankers, analysts at rival Moody’s Investors Service did not share Fitch’s qualms. On Monday, Moody’s rated a slice of the bonds AAA. Kroll Bond Ratings, another Fitch competitor, had already affixed its AAA rating to a slice of the deal.

But for Fitch, the episode isn’t over. Somerville, the Fitch managing director, now cites the Citi bond deal as a sign of what he portrays as a dangerous trend -- the resumption of ratings that are not reliable, their details determined by something less than a rigorous process, injecting risk and uncertainty throughout the financial system.

In the prelude to the Great Recession, as major Wall Street banks turned sub-prime home mortgages into the raw materials for a lucrative trade in securities, bankers generally got what they wanted, according to insider accounts. They ran roughshod over credit rating agencies that dared question the deals they put together, while taking their business to more pliable alternatives.

The result: a kind of reverse alchemy that turned trillions of dollars into so-called toxic securities. The investments built of mortgages became nearly worthless as the markets absorbed the reality that many of the assumptions undergirding their value were bogus. As home prices fell and homeowners sunk into default, bonds built of mortgages became risky assets prone to default -- and never mind the AAA ratings. Savers who had assumed that their AAA investments made them impervious even to financial catastrophe lost huge sums.

“The loans last 10 years, but the memory of them lasts seven years,” Somerville said. “We’re coming up on seven years. People have forgotten how bad it was last time.”

As head of the group that rates commercial mortgage-backed securities for Fitch, Somerville directs a group of analysts who pore over the details of bonds put together by Wall Street bankers, crunching numbers in a complex model to determine how likely it is those bonds will default. Those analysts only apply the top ‘AAA’ rating to instruments that are likely to pay off in all but catastrophic scenarios.

Somerville claimed analysts at other firms are not holding themselves to those lofty standards.

“This push to make loans and the competition to rate them to is making competition more aggressive,” Huxley said “We’re seeing transactions that are not being underwritten as conservatively as they should. If we continue to see what we’re seeing, it’s going to get worse, because it becomes a question of moving the limit, and moving the limit again, and moving the limit again.”

Eric Thompson is a senior managing director at Kroll Bond Ratings whose group was directly involved in rating the Citigroup deal. Analysts at that firm did not take the bankers' model estimates on future rent increases at 375 Park at face value when rating the bonds. But they did calculate a decrease in vacancy at the building and other factors would drive cash flow up to levels over $58 million a year, from current levels around $54 million. (The bankers’ more optimistic calculations pegged future cash flow at about $71 million yearly.)

“We sleep very well with the ratings that we put out in these securities,” Thompson said, noting their model indicated it would be unlikely AAA bonds would default even if cash flow from rents fell by 30 percent from estimates. “At the end of the day, even if there is a downturn, over the term of this loan, it’s fairly resilient.”

He added that competition from smaller agencies like his, rather than promote a deterioration of standards as Fitch is suggesting, was raising the bar on transparency and quality in the credit rating sector. Fitch was merely making a stink about the ratings on this current deal out of unhappiness that it failed to secure the business, and was being disingenuous by not releasing their full assessment of the deal.

"Fitch's opinion is a one-page document and whatever accusations come with it would have been better served by putting out their whole analysis," Thompson said. "375 Park is one subway stop away from Fitch’s office. If Fitch has a major problem with the sector, and they consider themselves an industry leader, they should put out their full report."

Thomas Lemmon, a spokesman for Moody’s, defended his company's rating on the unique quality of the loan underpinning it.

“This particular building is one of the premier buildings in the country,” Lemmon said. “We certainly gave that a lot more credit. We’re able to say that the building in good times would be able to do better, and even if it’s empty, it wouldn’t be valued at zero.”

Those explanations do not convince Somerville, a 17-year credit ratings veteran, who estimates if current credit rating industry practices go unchecked, the market is about two years away from a financial crisis like that one that began in late 2007.

“Everyone just needs to recognize what’s going on,” he said “The whole market needs to remind itself that we’re here for the long-run and not just for the next quarter.”

CORRECTION: The original story misidentified Kroll Bond Ratings as Kroll Rating Agency. It has been corrected.



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